Question

3. A worker within the middle income class is preparing to retire. In the year before he retired, his gross monthly earnings are $2,000. His Social Security benefits will be $1,200 per month. Before he retired, his income was subject to a tax of 25 percent. Find his before-tax and after-tax replacement rates

Answer 1

The replacement rate is the percentage of the final income that the pension compensates.

Before-tax replacement rate:

The worker made $2,000, and his social security benefits are $1,200.

1,200 x 100% / 2,000 = 60%

The before-tax replacement rate is 60%.

After-tax replacement rate:

His 2,000 income was subject to a 25% tax.

2,000 x 25% = 500

His after-tax income was 1,500

1,200 x 100% / 1,500 = 80%

The after-tax replacement rate is 80%.